This note examines the outlook for consumer and retail price inflation in 2010-11 from a "monetarist" perspective. The approach is to build up a forecast by considering in turn "core" inflation, VAT effects, food and energy prices and owner-occupied housing costs (relevant for the RPI).
The conventional "Keynesian" approach is to model core inflation as a function of the "output gap" with some allowance for the effect of exchange rate movements on import prices. The trouble with this is that the output gap is difficult to measure, particularly in real time, while currency movements are largely unpredictable. The consensus view, embodied in the MPC's Inflation Report forecast, is that a large negative gap has opened up and will persist in 2010-11, exerting sustained downward pressure on core inflation. Yet the financial crisis may have damaged supply capacity by more than the consensus assumes, by raising the cost of capital, disrupting its efficient allocation and reducing the sustainable size of the financial sector – the Treasury has cited estimates of a negative effect on potential GDP of up to 6%. History suggests that caution is warranted: an overestimate by policy-makers of the degree of economic slack contributed to the inflationary upsurge in the 1970s.
An alternative approach is to base a forecast for core inflation on the simplistic monetarist rule-of-thumb that the money supply leads prices with a variable lag averaging about two years. The monetarist rule has arguably performed much better than output gapology in recent years: a large fall in core inflation in the late 1990s was preceded by a major monetary slowdown, while faster money growth forewarned of the inflationary overshoot of 2007-08. The late 1990s disinflationary episode can be used to calibrate the possible impact of recent monetary weakness on core inflation. Annual growth in broad money M4 fell from 11.9% to 2.8% between Q4 1997 and Q3 1999 – a 9.1 percentage point drop. Annual core inflation – as measured by the CPI excluding unprocessed food and energy – subsequently declined by 1.9 percentage points to a low of just 0.1% in July 2000. So the "elasticity" of inflation to monetary growth was 0.21 (i.e. 1.9 divided by 9.1). Recent monetary trends are best measured by the Bank of England's adjusted M4 measure, excluding money holdings of financial intermediaries. Its annual growth rate fell from 11.6% in Q3 2006 to 3.6% in Q4 2008, rebounding to 4.2% in Q1 2009. Assuming that Q4 2008 was the low – reasonable given the positive impact of Bank of England gilt purchases in Q2 and Q3 2009 – the monetary slowdown suggests an eventual fall in annual core inflation of 1.7 percentage points (i.e. multiplying the money growth decline of 8.0 percentage points by the inflation elasticity of 0.21).
A major difference, however, between the late 1990s and now is a higher starting level of core inflation. The CPI excluding unprocessed food and energy rose by an annual 2.1% in May compared with 2.0% in February 1998, when the prior big slowdown began. However, recent numbers have been flattered by the temporary cut in the main rate of VAT from 17.5% to 15% last December. Assuming average pass-through of 60%, the core CPI measure would have risen by an annual 2.9% in May in the absence of the VAT change, down from a peak of 3.0% in February. (The 60% assumption may be conservative – the Office for National Statistics has estimated that 70% of prices collected from shops had been reduced to reflect the lower VAT rate in January.) Applying the predicted 1.7 percentage point fall in annual core inflation to the 3.0% February peak, the monetarist approach suggests an eventual trough of 1.3% – well above the 0.1% low reached in 2000. Assuming a two-year lead of money on prices, this trough could be reached around the end of 2010, with the recent recovery in monetary growth reflected in higher core inflation in 2011.
The outlook for headline CPI and RPI inflation will also depend on future VAT effects, food and energy prices and housing costs. The forecasts below assume that the planned return in the main VAT rate to 17.5% from January 2010 goes ahead, again with average pass-through of 60%. A further 1 percentage point increase is pencilled in for January 2011, on the basis that higher VAT will bear some of the burden of future fiscal consolidation. Unprocessed food inflation – still running at an annual 9.3% in May – is assumed to fall significantly by the end of 2009 but to remain positive, reflecting a judgement that the large increase in prices over 2007-09 reflected a "structural" shift. Following a modest further cut in retail tariffs later this year, energy prices are similarly projected to trend gradually higher. For the RPI forecast, the components linked to house prices are assumed to stabilise from late 2009 after a 20% drop from the peak. Finally, the average mortgage interest rate – currently 3.6% – is projected to fall slightly further over the remainder of 2009 before recovering by about 1 percentage point during 2010, reflecting an assumed rise in Bank rate from 0.5% to 2.5% next year.
The results of this exercise are shown in the chart. Annual CPI inflation falls from its current 2.2% towards 1% by autumn 2009, reflecting favourable food and energy price effects, but rebounds to about 3% in early 2010 as VAT is hiked. Slower core trends gradually reverse this increase and inflation moves temporarily below 2% again in early 2011 as a result of VAT effects (i.e. a smaller rise in 2011 than 2010), before drifting higher later in the year in lagged response to the current pick-up in monetary growth. Mirroring the CPI profile, the annual RPI change moves deeper into negative territory into the autumn but increases much more sharply in 2010, with the VAT increase compounded by a big turnaround in the housing costs component, reflecting both unfavourable base effects and higher mortgage rates. Annual RPI inflation peaks at about 3.5% in late 2010, slowing temporarily during the first half of 2011 as housing effects wane.
Two features of this forecast are worth emphasising. First, the CPI profile is significantly higher than the central projection in the May Inflation Report, which shows average inflation of 1.5% this year, 0.9% in 2010 and 1.3% in 2011. The difference mainly reflects the sustained disinflationary influence of a negative output gap in the Bank of England's forecasting model, although assumptions about VAT and commodity prices may also contribute. The MPC's recent forecasting record warrants some scepticism about its current prognosis: the central projection for annual CPI inflation one year ahead has been too low in 15 out of 17 Inflation Reports between February 2004 (after the inflation target was switched to the CPI from RPIX) and February 2008, with a mean forecast error of 0.7 percentage points.
Secondly, the swing in RPI inflation between 2009 and 2010 is unusually large and may have negative economic implications. Wage growth has slowed sharply since the onset of the recession in spring 2008 but it is unclear whether this reflects labour market flexibility or is simply a response to annual RPI falls. A pick-up in wage settlements as RPI inflation rebounds in 2010 would cast doubt on the MPC's view that economic slack will drive core price trends significantly lower. On the other hand, continued weak wage growth would imply a squeeze on real disposable incomes, potentially undermining prospects for consumer spending and an economic recovery.
